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Protect Yourself from the Unknown Unknowns

Apr 30, 2013Chad Karnes, CMTInvestors usually focus their risk management on the hazards they know about. However, it's frequently the risks we don't see that pose the biggest threats to our portfolios. Luckily, we have ways to protect capital.

In 2010 it was the "Flash Crash" that sent markets spiraling down
17%.

In 2011 it was the debt ceiling debacle and the corporate fraud
of MF Global that sent markets down over 20%.

This was followed up in 2012 by Knight Capital's $440MM
trading "glitch".

And just the other day we had a mini-flash crash on the
S&P futures all because of a false tweet from a news outlet.

How many of these events were predicted (the
answer is none)?

As if investing wasn't already difficult enough, it is the
things we don't know, the "unknown unknowns" that can really hurt us. We call them rogue waves.

As the examples above demonstrate, not having protection in this environment is
downright dangerous. Luckily we have
some options.

A look at the most recent Rogue Wave

Before we talk about the recent
mini-flash crash, here's a quick recap about the significance of rogue waves (sometimes referred to as "Black Swans"):"Rogue waves (also known as freak waves) are large and spontaneous
ocean surface waves that occur at sea and are a threat even to very large ships
and ocean liners. In oceanography terms, any waves whose height is more than
twice the significant wave height (SWH), is considered rogue. Interestingly,
rogue waves are not necessarily the largest waves found at sea, but instead,
unexpectedly big waves for a certain ocean atmosphere. Furthermore,
exceptionally large waves are often caused by a conglomeration of factors,
rather than just one."
Rogue waves don't just exist in nature, but in financial markets too...unexpectedly big waves that occur given a certain, usually relaxed, atmosphere.

On Tuesday 4/24, at 1:09 eastern time, the markets (NYSEARCA:VTI) plunged
on the back of a "hacked" Tweet from the Associated Press. This was a financial rogue wave.

Within a few minutes, the S&P 500 (NYSEARCA:SPY) was down over 1%
instantly wiping out over $130B in wealth.
The chart below captures that moment.
Needless to say, no one expected such an event.

This time the markets quickly corrected, and the wealth was
regained. But, the bigger questions
should be, what if next time the markets don't snap back so effectively? Or, what if the rumor was actually true? Portfolio protection is definitely needed to mitigate such risks.

"The Unknown Unknowns"

In the ETF Profit Strategy Newsletter one of our "Mega
Investment Themes" has been protection from rogue waves. In this day and
age of extremely high correlations there is a greater potential for unforeseen
(and even unrelated) events to affect your portfolio. We will never know exactly what they are, but we do know they will occur.

This is why we have been big advocates of buying portfolio protection
during times of low costs and high complacency. The most recent was in late as March when the
VIX (CHICAGOOPTIONS:^VIX) was trading at 11.30.

On 3/17 in the ETF Technical Forecast we identified the high
level of complacency (and increased levels of risk) shown by historically low volatility (NYSEARCA:VXX), historically high levels of "dumb
money" speculative buyers, and extreme levels of bullish sentiment (NYSEARCA:VIXY).

All of these were signs that the market was ripe for a
surprise, which indeed occurred in mid-April as the markets pulled back 4% and
the VIX shot up to 18 by mid-April (up 50%+ from our March suggestion).

We also were advocates of buying the VIX on 1/23 when the VIX
was at 12.46 as well as throughout December where we suggested, "Buying below
16 and certainly below 15 remains a good
strategy to hedge your portfolio or capitalize on volatility". Each of these instances saw a VIX (NYSEARCA:UVXY) spike to at a minimum the upper teens.

The chart shown below provided to subscribers on 3/17
highlights some of the long VIX recommendations over the past year (red arrows). Using technical analysis and relative
strength techniques we have been able to identify ideal times to hedge your
portfolio from known and unknown risks by buying volatility options and ETFs
when they were cheap.

What Next?

The rogue wave from 4/23 is just one example of an infinite
amount of unknown unknowns that can affect your portfolio adversely. Using our technique of buying volatility
calls would have protected you during the recent flash crash as the VIX
and its ETFs rallied over 8% that day as the final chart shows.

Many volatility options shot up over 100% in that few minute
period, certainly protecting, but also allowing investors to profit from rogue waves.

We certainly will never know all the unknowns out there, but
that doesn't mean we shouldn't try to protect our portfolios from such unpredictable
events. VIX call options and various
Exchange Traded Products can be used to help hedge downside risk. (But, beware of some of the risks of Volatility
ETPs explained here)

It also doesn't mean we should just buy the VIX
blindly. Just as with any investment, there
are better times to buy than others. The ETF Profit Strategy Newsletter uses the VIX along with technical analysis and sentiment
measures to find the better times to protect your portfolio as well as identify
high probability trading set ups for stocks, bonds, forex, and commodities.